Question

Write a research report that outlines the topics -

• Determine how diversification is important in the formation of CAPM.
• Provide numerical illustrations for CAPM.
• Research the validity of CAPM.

Answer 1

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Investors confront two main types of risk when investing. The first is undversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification—it is just a risk investors must accept.

Thus, by diversifying, investors are trying to reduce the risks associated with the investments by making investments in different types of security.

CAPM formula= Rf + (Ra- Rf) * B

Where Rf is risk free rate

Rm = Market rate of return

Rm- Rf = Market risk premium

B= Beta

Thus,

CAPM = 2.5 % + (1.25 ) * 8

= 12.5 %

Capm is important in finance because it gives investor an idea on the required rate of return

Thus, it becomes beneficial to the investors to invest accordingly as per their judgements.